How Currencies Are Valued – Exchange Rates and What Moves Them

If you go on vacation or on a business trip abroad, and decide to buy something in a gift shop, restaurant, or get gas for a rented car, you will have to account for the difference in that country’s currency compared to your own. The country’s currency could be worth more or less than your home’s, but there are many factors behind this as well as implications for the economies of both countries. The value of a nation’s currency affects investment, inflation, and most commonly, trade. However, there are reasons behind the changes in the value of money.

 

The first and biggest of these reasons is basic supply and demand. For example, if investors wanted to buy U.S. securities such as stocks and bonds for popular reasons such as stability and greater guarantee on return, they would need dollars to make those purchases. This raises demand for the U.S. dollar, making the currency increase in value, compared to foreign currencies. The same thing happens when demand decreases for a currency, so does its value, and therefore its buying power outside its native country.

 

There are many common factors behind the demand for a currency. Take the U.S. for example. When the Fed raises interest rates, that means investors will be getting higher return on their investments, so demand for U.S. assets increases. On the other hand, when the U.S. or any other country experiences inflation due to an unhealthy economy, the demand for the currency decreases, along with its value. 

 

Another factor is the balance between imports and exports. When a country exports more than it imports, foreigners need that country’s currency to buy the exports, increasing the demand for the currency. However, when a country does the opposite, a trade deficit as mentioned in a previous post, that nation’s currency may depreciate. However, that is not always the case. If a nation’s economy is still strong and trusted globally, running trade deficits can still be functional without harming the currency value - as is the case with the U.S.

 

Government actions can also change exchange rates. Some governments like China handle their currencies tightly to support exports while others, like the U.S., let markets decide freely. Small policy changes such as tweaking interest rates can have great effects on foreign buying power of a nation. 

 

Finally, large events such as wars, elections, or strife can motivate investors to move away from a currency which has predicted instability due to the state of its nation and prefer more stable and “safer” currencies, traditionally seen in the U.S. dollar or Swiss franc.

 

In the end, what the value of a nation’s currency ultimately indicates is how other nations view their economy. The better the reputation, the more buying power the currency will have.